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Development in practice on intragroup expenses (Oriflame case)

On December 4, 2014, Moscow Arbitration Court handed down the decision in case № А40-138879/14-75-404.

This case concerned a dispute between OOO Oriflame Cosmetics and the Moscow Department of FTS Russia over the lawfulness of booking royalties paid to an affiliated foreign company in the Netherlands under a franchise agreement as deductible costs. Under the agreement royalties were paid for use of trademarks, trade names and protected commercial information on business methods and sales accounting. The license fee for trademark use was set at 2% of the cost of goods imported into the RF by the taxpayer under an agreement with an affiliated supplier in Luxembourg. Payments for use of the trade name and commercial information were set as annual fixed amounts.

The outcome of the dispute was that the court took the side of the tax authority.

The court agreed with the tax authority that the Russian taxpayer in this case is a permanent establishment of a foreign organization - the supplier of the goods the taxpayer sells in Russia, and ruled that although "formally the Claimant is registered as a Russian legal entity", it "effectively acted on behalf and in the interests of a foreign company".

The court noted that it applied the doctrine of "piercing the corporate veil", which is intended to prevent misuse of legal entity status. The court found that consumers of the services offered by the taxpayer had a firm impression that the taxpayer was the representative of an affiliated foreign company, the Luxembourg resident.

The court reached this finding after studying the corporate website of the Oriflame group, including the Russian-language section, the taxpayer’s corporate documents (in particular, the Success Plan describing the taxpayer’s interactions with consultants distributing its products), and online advertisements. The court indicated that the goods catalog, goods advertising, and the contents of the Internet resource used by consumers wishing to obtain information about the goods give consumers the impression that the foreign company has a representative office in Russia. The court also cited evidence (records of questioning employees) demonstrating that the taxpayer had limited authority to make decisions on the conduct of its business and that such decisions were dependent on its foreign affiliates.

The court also took into consideration a letter from the Luxembourg tax authorities stating that the royalties paid by the taxpayer are not taxable for the foreign affiliate – the end beneficiary of the royalties (via the Netherlands resident) in Luxembourg.

As a result, the court held that since the taxpayer is a permanent establishment of a foreign company resident in Luxembourg that is the ultimate beneficiary of the royalties, the conclusion of a franchise agreement shows that the taxpayer has obtained an unjustified tax benefit by increasing its costs in the amount of the deduction of royalties. . The court did not apply any rules on determining the costs of permanent establishments, in particular, art. 307.9 RF TC and transfer pricing rules (section V.I RF TC).

In our view, the court's decision in this case is wrong and inconsistent with the RF TC rules on permanent establishments of foreign organizations (art. 306, 307 RF TC) and the applicable agreements on the avoidance of double taxation (with the Netherlands and Luxembourg), as well as international practices in development of this institution, expressed, in particular, in the OECD Commentaries on the Model Tax Convention on Income and Capital.

Nevertheless, this decision suggests a potential change in the way tax authorities and commercial courts approach tax disputes concerning "intragroup costs" of Russian organizations (payments for services and rights to intellectual property provided by foreign affiliates), and the criteria applicable in assessing whether such costs can be deducted for tax purposes.

We recommend carrying out a reassessment of tax risks relating to intragroup expenses, especially royalties for use of intellectual property and know-how (commercial information), and the risk of Russian subsidiaries of multinational companies being deemed permanent establishments of foreign organizations.

The Dentons tax practice team is ready to bring its extensive experience in related advice and litigation to bear on analyzing tax risks relating to the scope and structure of intragroup expenses of Russian companies and whether they meet permanent establishment criteria, and to develop approaches and recommendations for modifying documentation to eliminate or substantially mitigate any risks found.

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